Personal Finance: A simpler way to invest in property without owning it directly

A real estate investment trust, or REIT, is a specialized corporate setup created to own or run income-producing real estate, or to hold debt tied to property. Congress established the structure in 1960 so individual investors could gain access to commercial real estate through companies built to manage property. In that sense, REITs work a bit like mutual funds or ETFs, giving everyday investors a way to participate in a portfolio of assets. They are governed by separate tax rules that can make them appealing to income-seeking investors, while also adding complexity at tax time.

To qualify as a REIT, a company must place at least 75% of its assets in real estate, cash or Treasuries, and earn at least 75% of its gross income from rents, mortgage interest or property sales. It also needs at least 100 shareholders and must be managed by a board of directors or trustees.

Just as important, the company must distribute at least 90% of its taxable income to shareholders each year. Meeting those standards allows a REIT to avoid corporate-level taxation and pass net income through to investors. That is very different from most public companies, which pay taxes on earnings first and then distribute some of what remains as dividends that can be taxed again at the individual level. Avoiding that double taxation can translate into higher cash payouts for investors who understand the risks and tax consequences.

Before 1960, commercial real estate investing was mostly available to wealthy individuals, family partnerships, insurance companies and pension funds. Earlier real estate trusts had benefited from favorable tax treatment in the late 1800s and early 1900s, but federal tax changes in the 1930s brought many of them under corporate taxation. That removed much of the tax advantage that had made the structure appealing in the first place.

The real estate industry later pushed for legislation that would restore pass-through treatment, but President Dwight D. Eisenhower vetoed the first major REIT bill in 1956 over concerns about federal tax revenue. Four years later, he signed the measure that created the modern REIT structure. Congress, in typical fashion, tucked the REIT language deep into the Cigar Excise Tax Extension Act of 1960. Today, there are about 200 publicly traded REITs worth more than $2.5 trillion, and the S&P 500 includes 28 real estate trusts.

REITs generally fall into two broad categories. Equity REITs own physical properties and collect rent. They make up most of the market and cover a wide range of sectors, including apartments and rental homes, industrial warehouses and logistics hubs, healthcare properties, retail centers and office buildings. In recent years, specialty areas such as cell towers and data centers have also grown.

With most equity REITs, depreciation is a major non-cash expense on the income statement. It lowers reported earnings but does not reduce actual cash flow. For that reason, analysts often look instead at funds from operations, or FFO, which adds depreciation back and removes property sale gains to better estimate cash available for shareholders. That measure is especially useful when judging whether a payout is sustainable.

Mortgage REITs, or mREITs, do not own buildings directly. Instead, they hold mortgages or mortgage-backed securities, which usually offer higher yields but also bring added risk. Many use leverage to boost returns, though leverage cuts both ways and can magnify losses as well.

Diversified equity REIT funds are often on the lower-risk end of the spectrum, and their yields tend to be more modest as a result. These funds often focus on slower-growing, more mature areas such as net-lease warehouses, office properties and traditional retail.

At the other extreme are mortgage REITs, some of which yield 9% to 10% or more. Those payouts reflect real risks, including leverage, interest-rate sensitivity and credit exposure. Many mREITs have slashed dividends and suffered steep share-price declines during periods of stress. A large distribution can be quickly erased if the underlying value falls.

Because REITs pay out most of their annual income, they usually keep very little capital for expansion. As a result, they often need to issue new shares or borrow money to buy more properties or mortgages, which makes them more dependent on interest rates and capital markets. REIT yields are typically higher than those of the broader stock market, but dividend income should not be the only factor investors consider.

Along with higher yields, REITs come with tax issues that deserve attention. Most REIT dividends are taxed as ordinary income rather than at the lower rates applied to qualified dividends from many other stocks. For investors in higher tax brackets, that can take a noticeable bite out of the return. There is some relief, however: shareholders can generally deduct up to 20% of qualified REIT dividends, which helps soften the impact.

A year-end tax statement, usually on Form 1099, may also include other types of distributions from real estate investments. A return of capital may be paid when distributions exceed earnings. That money is not taxed immediately, but it lowers the investor’s cost basis and can increase the eventual capital gain when the shares are sold. REITs may also sometimes make capital gains distributions, which are generally taxed at 15% if they qualify as long-term gains, meaning the holding period exceeded one year.

Because REIT income is often taxed as ordinary income, many investors choose to hold these investments in tax-advantaged accounts such as IRAs and 401(k)s.

Real estate investment trusts provide exposure to commercial property, liquidity and diversification alongside traditional stocks and bonds, and they often offer appealing income relative to their risks. Investors can buy individual REITs or choose from a wide range of professionally managed real estate funds that package multiple REITs into one investment. For many balanced portfolios, a modest and focused allocation may be worth considering.

Christopher A. Hopkins, CFA, is a co-founder of Apogee Wealth Partners in Chattanooga.